Don’t close last yera’s4 income tax return files just yet. You should use that tax return to plan for the rest of this year and even next year. Tax planning should be a year-round activity these days, and last year’s tax return is the best place to start. The federal income tax return also is one of the best financial planning documents available. Scanning your tax return with an educated eye reveals much about your finances and provides some tips for increasing your net worth.
First, determine your tax rates. Yes, you have more than one tax rate. The average or effective tax rate is your total income taxes paid divided by the gross income for the year. That’s the percentage of your income that goes to federal income taxes (but not to all those other taxes you pay). Most retirees should be able to manage their income and assets to keep this tax rate around 20%, and many can keep it below 20%.
The second tax rate is your marginal tax rate, or the rate on your last dollar of income. For most people this is easily found with a quick look at tax tables. The tax tables also indicate whether you’re in danger of rising to the next higher bracket by earning a little more income or could fall to a lower tax bracket by reducing taxable income a bit. When you’re near either edge of your bracket, sharpen your tax planning.
Higher-income taxpayers pay a higher marginal tax rate than indicated in the tables, because some of their tax breaks are phased out. Computing the marginal rate in this situation is complicated and usually not worth the effort, but you should know your marginal rate is higher than the tax rate table says.
The third rate is your taxes divided by your net worth. This is a quick, rough way to see if you’re saving enough. As you approach retirement, you should have more assets than income, so the tax rate on your wealth should be 5% or so, hopefully less.
A review of the personal information on the return is next. Were there changes in your residence, marital status, or number of children (or grandchildren)? If so, arrange to meet with your financial or estate planner to discuss the effects of the changes.
Next, study the sources of income and your tax rates on those sources. Most retirees should have tax diversification, a mix of sources of income. Tax diversification provides flexibility and allows a person to manage income sources so that the average tax rate is around 20% or less.
Consider these strategies.
Reduce taxable investment income. When taxable investment income exceeds spending needs, seek ways to shelter some or all of the excess. Part of the portfolio might be moved into deferred fixed annuities or contributed to a Roth IRA. Or you can buy tax-favored investments such as stocks that pay qualified dividends. Tax-exempt bonds are another alternative to investments that generate interest income. Master limited partnerships also provide tax-advantaged income for the first 10 or 15 years you own them.
Review your mutual funds. Some mutual funds do a lot of trading each year and distribute a high percentage of their gains to shareholders. It doesn’t do you any good from a tax stand-point if you’re holding mutual funds for long-term capital gains but the funds are distributing most of their gains to you each year. If that describes some of your mutual funds, consider swapping them for funds with long-term tax-wise policies.
Practice tax-wise management of investments. A few simple moves during the year and can reduce your tax bill. Consider harvesting investment losses by selling investments with paper losses, taking the deduction, and reinvesting the proceeds. Sell appreciated investments only after they’ve been owned for more than one year so the gain qualifies as a long-term capital gain unless there are compelling reasons to sell sooner.
Even when an investment’s gain is long-term, consider the full tax effects before selling. A large long-term capital gain increases your adjusted gross income and might trigger the stealth taxes: taxing more Social Security benefits, higher Medicare premiums, reduction of itemized deductions, and other tax penalties.
Have the right assets in the right accounts. As a general rule, stocks and similar investments that you hold for the long-term should be in taxable accounts where you can take advantage of the long-term capital gains tax rate. Investments that generate ordinary income-bonds, real estate investment trusts, mutual funds or stocks that are held less than one year-should be held in tax-advantaged accounts such as traditional and Roth IRAs. Having the right asset allocation for you comes first. But when possible hold the right assets in the right accounts.
Manage retirement plan distributions. Distributions from IRAs and 401(k)s are taxed as ordinary income. One strategy is to limit withdrawals from retirement plans and annuities to only the amounts needed for spending and required by law or contract. On the other hand, required minimum distributions steadily increase as you get older. An alternative that attracts many people is to draw down traditional retirement accounts early. You can convert a traditional IRA to a Roth IRA or drawn down the account and use it to buy a permanent life insurance policy or set up a charitable remainder trust, among other strategies.
Take business loss deductions. Losses can come from a sole proprietorship, partnership, limited liability company, or subchapter S corporation. You might be able to turn a hobby into a business. You have to run the activity like a real business to meet the IRS’s rules for deducting losses. Talk with a tax advisor if you’re considering this strategy.
Review salary and business income. These are taxable as ordinary income, your highest rate, and also subject to payroll taxes. When you can, opt for non-taxable benefits or deferred salary instead of cash salary if you’re in a high tax bracket, at risk of rising to the next bracket, or incurring some of the stealth taxes. Caution: Don’t defer salary when you might be in a higher bracket in the future.
Now, shift your attention to the itemized expenses deducted on Schedule A of your return. These used to be a major planning opportunity, but deductions for individuals have been reduced over the years. Still there are actions to consider.
Should you pay off a mortgage or refinance your home? What about a home equity loan? Are there better ways to make your charitable gifts? Are you maximizing medical expense deductions (an opportunity frequently overlooked by older taxpayers.) You should meet with a financial advisor to evaluate these and other issues.
There also are deductions on the front page of Form 1040, known as deductions for AGI. They aren’t practical for many people age 55 and over, especially those already retired but review them to see if you’re taking full advantage.
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